There has been a great transformation in the nature of world trade over the
past three decades. Prior to the late 70s developing countries overwhelmingly
exported primary products rather than manufactured goods; one relic of that era
is that we still sometimes refer to wealthy nations as "industrial countries,"
when the fact is that industry currently accounts for almost twice as high a
share of GDP in China as it does in the United States. Since then, however,
developing countries have increasingly become major exporters of manufactured
goods, and latterly selected services as well.

From the beginning of this transformation it was apparent to international
economists that the new pattern of trade might pose problems for low-wage
workers in wealthy nations. Standard textbook analysis tells us that to the
extent that trade is driven by international differences in factor abundance,
the classic analysis of Stolper and Samuelson (1941) – which says that trade
can have very strong effects on income distribution – should apply. In
particular, if trade with labor-abundant countries leads to a reduction in the
relative price of labor-intensive goods, this should, other things equal,
reduce the real wages of less-educated workers, both relative to other workers
and in absolute terms. And in the 1980s, as the United States began to
experience a marked rise in inequality, including a large rise in skill
differentials, it was natural to think that growing imports of labor-intensive
goods from low-wage countries might be a major culprit.

But is the effect of trade on wages quantitatively important? A number of
studies conducted during the 1990s concluded that the effects of North-South
trade on inequality were modest. Table 1 summarizes several well-known
estimates, together with one crucial aspect of each: the date of the latest
data incorporated in the estimate.

For a variety of reasons, possibly including the reduction in concerns about
wages during the economic boom of the later 1990s, the focus of discussion in
international economics then shifted away from the distributional effects of
trade in manufactured goods with developing countries. When concerns about
trade began to make headlines again, they tended to focus on the new and novel
– in particular, the phenomenon of services outsourcing, which Alan Blinder
(2006), in a much-quoted popular article, went so far as to call a second
Industrial Revolution. Until recently, however, surprisingly little attention
was given to the increasingly out-of-date nature of the data behind the
reassuring consensus that trade has only modest effects on income distribution.
Yet the problem is obvious, and was in fact noted by Ben Bernanke (2007) last
year: "Unfortunately, much of the available empirical research on the influence
of trade on earnings inequality dates from the 1980s and 1990s and thus does
not address later developments." And there have been a lot of later
developments.

Figure 1 shows U.S. imports of manufactured goods as a percentage of GDP
since 1989, divided between imports from developing countries and imports from
advanced countries.[1] It turns out that developing-country imports have
roughly doubled as a share of the economy since the studies that concluded that
the effect of trade on income inequality was modest. This seems, at first
glance, to suggest that we should scale up our estimates accordingly. Bivens
(2007) has done just that with the simple model I offered in 1995, concluding
that the distributional effects of trade are now much larger.

And there’s another aspect to the change in trade: as we’ll see, the
developing countries that account for most of the expansion in trade since the
early 1990s are substantially lower-wage, relative to advanced countries, than
the developing countries that were the main focus of concern in the original
literature. China, in particular, is estimated by the Bureau of Labor
Statistics (2006) to have hourly compensation in manufacturing that is equal to
only 3 percent of the U.S. level. Again, this shift to lower-wage sources of
imports seems to suggest that the distributional effects of trade may well be
considerably larger now than they were in the early 1990s.

But should we jump to the conclusion that the effects of trade on
distribution weren’t serious then, but that they are now? It turns out that
there’s a problem: although the "macro" picture suggests that the
distributional effects of trade should have gotten substantially larger,
detailed calculations of the factor content of trade – which played a key role
in some earlier analyses – do not seem to support the conclusion that the
effects of trade on income distribution have grown larger. This result, in
turn, rests on what appears, in the data, to be a marked increase in the
sophistication of the goods the United States imports from developing countries
– in particular, a sharp increase in imports of computers and electronic
products compared with traditional labor-intensive goods such as apparel.

Lawrence (2008), in a study that shares the same motivation as this paper,
essentially concludes from the evidence on factor content and apparent rising
sophistication that the rapid growth of imports from developing countries has
not, in fact, been a source of rising inequality. But this conclusion is, in my
view, too quick to dismiss what seems like an important paradox. On one side,
the United States and other advanced countries have seen a surge in imports
from countries that are substantially poorer and more labor-abundant than the
third-world exporters that created so much anxiety a dozen years ago. On the
other side, we seem to be importing goods that are more skill-intensive and
less labor-intensive than before. As we’ll see, the most important source of
this paradox lies in the information technology sector: for the most part there
is a clear tendency for developing countries to export labor-intensive
products, but large third-world exports of computers and electronics stand out
as a clear anomaly.

One possible resolution of this seeming paradox is that the data on which
factor-content estimates are based suffer from severe aggregation problems –
that developing countries are specializing in labor-intensive niches within
otherwise skill-intensive sectors, especially in computers and electronics.
I’ll make that case later in the paper, while admitting that the evidence is
fragmentary. If this is the correct interpretation, however, the effect of
rapid trade growth on wage inequality may indeed have been significant.

The remainder of this paper is in four parts. The first part offers an
overview of changing U.S. trade with developing countries, in a way that sets
the stage for the later puzzle. The second part describes the theoretical basis
for analyzing the distributional effects of trade, then shows how macro-level
calculations and factor content analysis yield divergent conclusions. The third
part turns to the case for aggregation problems and the implications of
vertical specialization within industries. A final part considers the
implications both for further research and for policy. ...

Implications of the analysis

The starting point of this paper was the observation that the consensus that
trade has only modest effects on inequality rests on relatively old data – that
there has been a dramatic increase in manufactured imports from developing
countries since the early 1990s. And it is probably true that this increase has
been a force for greater inequality in the United States and other advanced
countries.

What really comes through from the analysis here, however, is the extent to
which the changing nature of world trade has outpaced our ability to engage in
secure quantitative analysis—even though this paper sets to one side the growth
in service outsourcing, which has created so much anxiety in recent years.
Plain old trade in physical goods has become remarkably exotic.

In particular, the surge in developing-country exports of manufactures
involves a peculiar concentration on apparently sophisticated products, which
seems at first to put worries about distributional effects to rest. Yet there
is good reason to believe that the apparent sophistication of developing
country exports is, in reality, largely a statistical illusion, created by the
phenomenon of vertical specialization in a world of low trade costs.

How can we quantify the actual effect of rising trade on wages? The answer,
given the current state of the data, is that we can’t. As I’ve said, it’s
likely that the rapid growth of trade since the early 1990s has had significant
distributional effects. To put numbers to these effects, however, we need a
much better understanding of the increasingly fine-grained nature of
international specialization and trade.

There has been a great transformation in the nature of world trade over the
past three decades. Prior to the late 70s developing countries overwhelmingly
exported primary products rather than manufactured goods; one relic of that era
is that we still sometimes refer to wealthy nations as "industrial countries,"
when the fact is that industry currently accounts for almost twice as high a
share of GDP in China as it does in the United States. Since then, however,
developing countries have increasingly become major exporters of manufactured
goods, and latterly selected services as well.

From the beginning of this transformation it was apparent to international
economists that the new pattern of trade might pose problems for low-wage
workers in wealthy nations. Standard textbook analysis tells us that to the
extent that trade is driven by international differences in factor abundance,
the classic analysis of Stolper and Samuelson (1941) – which says that trade
can have very strong effects on income distribution – should apply. In
particular, if trade with labor-abundant countries leads to a reduction in the
relative price of labor-intensive goods, this should, other things equal,
reduce the real wages of less-educated workers, both relative to other workers
and in absolute terms. And in the 1980s, as the United States began to
experience a marked rise in inequality, including a large rise in skill
differentials, it was natural to think that growing imports of labor-intensive
goods from low-wage countries might be a major culprit.

But is the effect of trade on wages quantitatively important? A number of
studies conducted during the 1990s concluded that the effects of North-South
trade on inequality were modest. Table 1 summarizes several well-known
estimates, together with one crucial aspect of each: the date of the latest
data incorporated in the estimate.

For a variety of reasons, possibly including the reduction in concerns about
wages during the economic boom of the later 1990s, the focus of discussion in
international economics then shifted away from the distributional effects of
trade in manufactured goods with developing countries. When concerns about
trade began to make headlines again, they tended to focus on the new and novel
– in particular, the phenomenon of services outsourcing, which Alan Blinder
(2006), in a much-quoted popular article, went so far as to call a second
Industrial Revolution. Until recently, however, surprisingly little attention
was given to the increasingly out-of-date nature of the data behind the
reassuring consensus that trade has only modest effects on income distribution.
Yet the problem is obvious, and was in fact noted by Ben Bernanke (2007) last
year: "Unfortunately, much of the available empirical research on the influence
of trade on earnings inequality dates from the 1980s and 1990s and thus does
not address later developments." And there have been a lot of later
developments.

Figure 1 shows U.S. imports of manufactured goods as a percentage of GDP
since 1989, divided between imports from developing countries and imports from
advanced countries.[1] It turns out that developing-country imports have
roughly doubled as a share of the economy since the studies that concluded that
the effect of trade on income inequality was modest. This seems, at first
glance, to suggest that we should scale up our estimates accordingly. Bivens
(2007) has done just that with the simple model I offered in 1995, concluding
that the distributional effects of trade are now much larger.

And there’s another aspect to the change in trade: as we’ll see, the
developing countries that account for most of the expansion in trade since the
early 1990s are substantially lower-wage, relative to advanced countries, than
the developing countries that were the main focus of concern in the original
literature. China, in particular, is estimated by the Bureau of Labor
Statistics (2006) to have hourly compensation in manufacturing that is equal to
only 3 percent of the U.S. level. Again, this shift to lower-wage sources of
imports seems to suggest that the distributional effects of trade may well be
considerably larger now than they were in the early 1990s.

But should we jump to the conclusion that the effects of trade on
distribution weren’t serious then, but that they are now? It turns out that
there’s a problem: although the "macro" picture suggests that the
distributional effects of trade should have gotten substantially larger,
detailed calculations of the factor content of trade – which played a key role
in some earlier analyses – do not seem to support the conclusion that the
effects of trade on income distribution have grown larger. This result, in
turn, rests on what appears, in the data, to be a marked increase in the
sophistication of the goods the United States imports from developing countries
– in particular, a sharp increase in imports of computers and electronic
products compared with traditional labor-intensive goods such as apparel.

Lawrence (2008), in a study that shares the same motivation as this paper,
essentially concludes from the evidence on factor content and apparent rising
sophistication that the rapid growth of imports from developing countries has
not, in fact, been a source of rising inequality. But this conclusion is, in my
view, too quick to dismiss what seems like an important paradox. On one side,
the United States and other advanced countries have seen a surge in imports
from countries that are substantially poorer and more labor-abundant than the
third-world exporters that created so much anxiety a dozen years ago. On the
other side, we seem to be importing goods that are more skill-intensive and
less labor-intensive than before. As we’ll see, the most important source of
this paradox lies in the information technology sector: for the most part there
is a clear tendency for developing countries to export labor-intensive
products, but large third-world exports of computers and electronics stand out
as a clear anomaly.

One possible resolution of this seeming paradox is that the data on which
factor-content estimates are based suffer from severe aggregation problems –
that developing countries are specializing in labor-intensive niches within
otherwise skill-intensive sectors, especially in computers and electronics.
I’ll make that case later in the paper, while admitting that the evidence is
fragmentary. If this is the correct interpretation, however, the effect of
rapid trade growth on wage inequality may indeed have been significant.

The remainder of this paper is in four parts. The first part offers an
overview of changing U.S. trade with developing countries, in a way that sets
the stage for the later puzzle. The second part describes the theoretical basis
for analyzing the distributional effects of trade, then shows how macro-level
calculations and factor content analysis yield divergent conclusions. The third
part turns to the case for aggregation problems and the implications of
vertical specialization within industries. A final part considers the
implications both for further research and for policy. ...

Implications of the analysis

The starting point of this paper was the observation that the consensus that
trade has only modest effects on inequality rests on relatively old data – that
there has been a dramatic increase in manufactured imports from developing
countries since the early 1990s. And it is probably true that this increase has
been a force for greater inequality in the United States and other advanced
countries.

What really comes through from the analysis here, however, is the extent to
which the changing nature of world trade has outpaced our ability to engage in
secure quantitative analysis—even though this paper sets to one side the growth
in service outsourcing, which has created so much anxiety in recent years.
Plain old trade in physical goods has become remarkably exotic.

In particular, the surge in developing-country exports of manufactures
involves a peculiar concentration on apparently sophisticated products, which
seems at first to put worries about distributional effects to rest. Yet there
is good reason to believe that the apparent sophistication of developing
country exports is, in reality, largely a statistical illusion, created by the
phenomenon of vertical specialization in a world of low trade costs.

How can we quantify the actual effect of rising trade on wages? The answer,
given the current state of the data, is that we can’t. As I’ve said, it’s
likely that the rapid growth of trade since the early 1990s has had significant
distributional effects. To put numbers to these effects, however, we need a
much better understanding of the increasingly fine-grained nature of
international specialization and trade.